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March 15, 1999

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Subject: Al's questions for me
Author: TMFRalegh

Al,
While I do pay a good deal of attention to the PC industry, I have to shy away from the label of "expert." I have expressed numerous thoughts on Gateway's competitive position on both the Boring and Gateway boards, so I hope it's okay if I don't repeat everything I've written already.

First, as an owner of Dell, I don't identify at all with your thought that "Dell owners don't seem to be worried about Gateway" encroaching on Dell's turf. This isn't the sort of industry where you go to sleep because you rule the roost. You screw up in this sort of industry for just a few quarters and that can mean real trouble. As far as I'm concerned, there are very few companies where you can stop worrying about the competition. Coke might fit into that category, but that's one of the few. And even then, not having a healthy paranoia about your competitive position can be very costly.

Second, we bought Gateway because its business model is superior to the rest of the industry, save for Dell and Micron. I deliberated on Micron as well, but I liked what Ted Waitt and his management is doing with the Country Stores, YourWare, their Internet offerings, and the overall way they're thinking about how to drive their business forward.

We also bought it because it's not a Dell versus Gateway world. It's a direct PC company versus indirect PC company world. There's more than enough inefficiencies among the indirect competitors for both Dell and Gateway to do well. Dell is the largest direct vendor of PCs and Gateway is second.

The real competition is the no-name (white box) assemblers, Compaq, H-P, Packard Bell, IBM, the contract manufacturers, and the entire indirect model. One could have taken this approach to direct underwriters of auto insurance industry at the beginning of the decade and bought GEICO and Mercury General. Your insurance portfolio would have handily outperformed the S&P 500 and would have stomped 99% of the rest of the universe of insurance companies. That's because such companies were doing things better as a class. They were delivering more value to the customer and to shareholders.

When people look at the PC industry, they get hung up on market share and deem the leaders the winners. That's not the way to look at it. The questions are "who is taking market share" and "how are they doing it." Wealth creation can happen in a number of different ways. You can create something new, say the cure for a certain type of cancer. You can build up a highly defensible franchise with great margins, like Coca-Cola. Or you can streamline something old. Over the last 10 years and 30 years, the best performing stocks fit into the last category. I'm talking about Dell and Wal-Mart. There was nothing new about the PC when Dell came public. They were just doing it better and really started to accelerate when the other companies began to stumble with free-falling component prices. Wal-Mart really came into something that wasn't new -- retailing. Why didn't Woolworth or Kresge (K-Mart) beat them into the ground? Because they were afraid. You bet Sam Walton was paranoid. But he wasn't afraid.

We chose Gateway because we didn't and do not believe the PC is going to go away tomorrow or that suddenly it will become an unattractive industry. As I said in a recent article on the industry:

http://fnews.yahoo.com/fool/99/03/04/dna_990304.htm

there are a number of reasons why the direct manufacturers of PCs earn so much money. You have the economics of three different businesses combined and streamlined in one company. A direct PC company is:

1. A precision manufacturer of electronic equipment
2. Its own distributor
3. Its own retailer

For Compaq, you have #2 and #3 collecting a cut of the profit somewhere along the line. For Dell and Gateway, you really don't, even though some integrators do buy Dells and re-sell them. Finally, there's an embedded option in these companies' values that they can get into the manufacture and distribution of other equipment. Dell's announcement with IBM is one example of that and both Dell and Gateway have committed themselves to general computer equipment retailing/wholesaling on the Internet with gigabuys.com and necx.com, respectively. Dell's price reflected that and Gateway's did not at the time. Also, Dell has hit the peak of profitability (as expressed by return on capital, not by margins) while Gateway has not. One of the reasons why Coke's shareholder return from 1981 has been so huge is because the company climbed to its potential profitability. The best time to have participated in that was while it was going on, not after. I'm not saying returns after that are poor, I'm saying your returns can be enhanced if you realized that while it was going on.

As for Compaq, its increase in margin is not important in comparison to Dell or Gateway. Compaq is a totally different sort of business with the acquisitions of DEC and Tandem. Tandem sells high margin systems but doesn't sell them as often. In the Bore port, we don't discriminate against margins. The story of value, financially, is not told solely by margins, in our opinion. It's told by return on capital, which is a function of both margins and asset activity. Expressed in the inverse, asset activity answers the question of "how many dollars of assets do I have to put in to get out a dollar of sales."

Coke is the perfect business because you get a good deal of sales out of a dollar of assets and you get great margins. Dell and Gateway are good businesses because they get a ton of sales out of a dollar of capital contributed to the business by investors, but their margins are low. Compaq is a poorer business because it doesn't get a lot of sales out of each dollar of assets and its margins are not that attractive. When we bought Gateway, we were buying about $1 in operating cash flow for about $11. At the same time, a dollar of operating cash flow at Compaq was selling for $100 and $19 on the previous year's cash flow. Dell was selling at about 55 times or so. That in itself doesn't prove anything, but we measured that against the growth opportunities of the companies and the rate of return on new investments and liked Gateway's value best. I would never have considered Compaq to begin with, anyway, and Dell was outside of what we would want to pay for the business at that time.

So we chose the high quality business model in the PC industry and we went with the company we felt offered the best value for us. That was Gateway.

Dale

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